Fluctuations in the Economic Storm
Domini Baldwin, Associate Director
Those of us who work in the construction industry will have seen the recent uncertainty in market conditions due to the June 2016 EU referendum and the Covid-19 pandemic. Construction industry output in the UK has been unpredictable in recent years, affecting many in the supply chain and making the delivery of some projects extremely challenging. The unpredictability has stemmed from an uncertain outlook for the UK and its key trade agreements, with added pressure now applied as a result of Covid-19. This unpredictability has slowed investor confidence and affected new work, consequently the value of the pound has been subject to large variations. Clients/Employers have therefore looked to secure their project values by excluding fluctuation provisions in their contracts. This has pressured many contractors to take the risk of fluctuations, even when forecasting trends do not lend themselves to predictable data. Where employers have taken on the risk of fluctuations, there can be issues obtaining further finance mid project and this puts strain on the whole operation.
In 2018 the National Building Specification (NBS) published the National Construction Contracts and Law Reporti which found that 81% of contracts were fixed price or lump sum. This demonstrates that fluctuation risks are overwhelmingly put back onto the contractor and the supply chain.
It is the ‘fixed price’ element that can be troublesome in construction.
It is a common misconception that ‘fixed price’ and ‘lump sum’ are one and the same. If you have a ‘fixed price lump sum’ contract the contractor generally assumes the risk of increases (or decreases) in the cost of items and the works are not subject to remeasurement. Such price changes would generally occur as a result of inflation. The Royal Institution of Chartered Surveyors (RICS) (2016) states, with respect to fluctuation rates:ii
This is defined as the general rate at which prices of materials and goods varies, usually upwards, and the consequent purchasing power of money decreases. Alterations to the price of items can also be caused by variations in taxation, ‘excise’ duties for domestically produced goods, ‘customs’ duties on imported goods, or those resulting from other fiscal policy influences.”
However, if you just have a ‘lump sum’ contract without a ‘fixed price’, and fluctuations are enabled, this means that the risk of increases (or decreases) is with the employer.
With statistics from the NBS report demonstrating that 62% of construction contracts entered into are under the JCT suite, I will set out an example of how fluctuations can be dealt with using the JCT Standard Building Contract 2016. This includes three options for calculating price adjustments which are benchmarked against the base date within the contract:
- Option A: Contribution, levy and tax fluctuations.
The contract states that “the Contract Sum is based upon the types and rates of contribution, levy and tax payable by a person in his capacity as an employer and which at the base date are payable by the Contractor”. This means that the contractor is not permitted to recover changes due to market conditions, such as variations in the price of construction materials or individually negotiated pay.
- Option B: Labour and materials cost and tax fluctuations.
Option B also permits adjustment of the kind outlined in Option A. This states that, as a default, the contract sum is based on:
- the rules and decisions of the Construction Industry Joint Council or other wage fixing body;
- any incentive scheme and/or productivity agreement under the Working Rule Agreement;
- the terms and conditions of the Building and Civil Engineering Annual and Public Holiday Agreements.
- Option C: Formula adjustment.
This method involves the use of the JCT Formula Rules and relies on a series of indices known as the Price Adjustment Formula Indices, which are maintained by the Building Cost Information Service (BCIS). The rules describe a ‘Base Month’, defined as the calendar month prior to that in which the tender is due to be returned, and contain a provision for the inclusion of a ‘non-adjustable element’; this would include, for example, overhead costs, insurance premiums, and the cost of items supplied directly by the contractor and which are therefore not subject to price increase during the contract period.
It is important to note that not all forms of contract enable fluctuations. I advise that you check this when pricing for your tender.
So, what does this all mean?
Labour Skills Gap
Between 2014 and 2016 the Office of National Statistics reported that non-UK nationals accounted for 41% of the construction of buildings workforce in London:iii
- 28% were EU8iv and EU2;v
- 5% were from other parts of the EU; and
- 8% were non-EU nationals.
Therefore, at this point, 33% of the construction of buildings workforce in London were EU nationals. Since Brexit, the number of EU nationals entering the country has decreased, whilst the number returning home has increased. This leaves the industry with a shortage of skilled labour, driving costs up due to high demand and low supply. The supply chain cannot afford to absorb this increased cost and employers will see tender prices increasing. Now, with more non-UK citizens returning home due to Covid-19, the situation has worsened.
Materials and Major Plant
The construction industry heavily relies upon imports to supply construction. Aside from import taxes, which are still in limbo, there is also the added risk of exchange rate fluctuations. The value of the Euro to Pound Sterling is ever-changing, the variation can be significant in just a matter of months. In 2019 the lowest rate reported was in August at 1.06 : 1.00 (€ : £) and the highest rate in December at 1.20 : 1.00 (€ : £).vi
To put this into context, if you have a £5 million pound cladding package budget on a fixed price lump sum contract, that was bid based upon an exchange rate of 1.20 : 1.00 (€ : £), but by the time you secured the package the exchange rate was 1.06 : 1.00 (€ : £), you could have lost €700,000 or £583,333. This can be a bitter pill to swallow for many.
|Amount in Pound Sterling||Exchange Rate||Amount in Euros|
|£ 5,000,000.00||1.20||€ 6,000,000.00|
|£ 5,000,000.00||1.06||€ 5,300,000.00|
|– € 700,000.00|
This example demonstrates the level of risk (or opportunity) that exists when importing goods from abroad, and why ensuring your contracts are ‘back to back’ is fundamental for understanding the inherent risks. There are various commercial decisions that can be made to reduce this risk, as set out in the next section.
What can be done commercially?
Depending on whether you are working for the employer or the contractor/supply chain, your commercial negotiation and risk profile will be different. However, the key tips when working on a lump sum contract arrangement are:
- Ensure that your base date aligns with the tender pricing date, not the date when the contract is signed. The RICS Fluctuations Guidance Note (2016) states:vii
“Although no guidance is given as to how this date is determined, it is generally accepted that this will be a date usually just prior to the date for return of tenders.”
- Enable fluctuations or make appropriate risk allowances. If you are entering into a non-negotiable contract whereby there are no fluctuations allowed, ensure that you diligently check trends in labour, material and exchange rate prices. These indices are available from various sources, including the BCIS and in-house data. This will help you to forecast possible changes that can be reflected within the tender price.
- Understand the contract form you are tendering for. You may believe that qualifying exchange rates at tender stage will reduce your risk, however this will be rendered insignificant if you have signed up to a lump sum contract which is also fixed price.
The current economic conditions are creating the perfect storm for disputes to arise due to pricing errors; this is owing to the inability to forecast accurately as a consequence of the ever-changing markets. The situation is now further complicated with the effects of Brexit and Covid-19. As to how these effects are differentiated is best described as challenging, hence the importance of understanding the risk of fluctuations remains paramount.
In February 2002, Donald Rumsfeld, the then US Secretary of State for Defense, stated at a department briefing that there are:
- ‘Known knowns’ – things we know that we know;
- ‘Known unknowns’ – things that we know we don’t know; but also
- ‘Unknown unknowns’ – things we do not know that we don’t know.
Whilst employers are often keen to pass the risk of fluctuations onto the supply chain, the supply chain may react by including exorbitant risk allowances to account for the ‘unknown unknowns’, making a project unfeasible due to budgetary constraints. Working together during the tender process will allow all parties to understand the perspectives of others and to find a procurement route which can create collaborative relationships. The key is to remain open and flexible during the procurement stage to ensure that the employer achieves value for money through effective supply chain management.
I have started to see contract amendments which make specific provisions for Brexit and pandemics, both of which can be contentious clauses to agree between parties. What has your experience been? Have you suffered at the hands of the unpredictable economic climate? I welcome your comments on the subject.
i National Building Specification (2018). National Construction Contracts and Law Report 2018. Newcastle upon Tyne, United Kingdom.
ii Royal Institution of Chartered Surveyors (2016). RICS professional standards and guidance, UK, Fluctuations. London, United Kingdom.
iii Office of National Statistics (2018). Migrant labour force within the UK’s construction industry: August 2018. Retrieved from Office for National Statistics: https://www.ons.gov.uk/peoplepopulationandcommunity/populationandmigration/internationalmigration/
articles/migrantlabourforcewithintheconstructionindustry/august2018 (accessed January 2020).
iv Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia.
v Bulgaria and Romania.
vi XE Currency Charts: GBP to EUR. Retrieved from XE Currency Converter: https://www.xe.com/currencycharts/?from=GBP&to=EUR&view=1Y (accessed January 2020).
vii Royal Institution of Chartered Surveyors (2016). RICS professional standards and guidance, UK, Fluctuations. London, United Kingdom.